Notwithstanding the central government's fiscal deficit consolidation since FY13 (year ending March 2013), a persistent rise in net issuances of bonds has weighed on the fixed income market. This has been primarily driven by deteriorating state's finances which has offset c. 50% of the central government's fiscal consolidation. The central government has reduced its fiscal deficit by c.140 basis points to 3.5% of GDP in FY17, since FY13. However, states fiscal deficit has simultaneously deteriorated to 2.8% of GDP from 2.0% in FY13 (excluding UDAY bond issuances of c.1.5% of GDP over last two years).

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Thus, a rapid pace of increase in states' market borrowings (c.20% CAGR) over the past five years has not come as a surprise. States' market borrowings are likely to remain high over the next few years too, as states' fiscal deficits are likely to remain wide (c.3% of GDP) on (i) additional annual interest payment of UDAY bonds issuances (c. 0.15% of GDP) and (ii) upward revision in salaries of government employees as recommendations of the 7th Pay Commission are implemented (aggregate burden of c.1% of GDP is likely to be spread over three-four years). Moreover, the recent announcement by Uttar Pradesh – India's largest state – that it would waive farmers' loans and issue farmer-relief bonds worth Rs 36,400 crore (c.0.2% of GDP), could exacerbate supply pressure in the bond market, especially if other states follow suit.

Since outstanding states' borrowings are more than 40% of government bond markets, a corrective plan of action to discipline state finances, is necessary. In this context, if the government accepts the recommendations of the Fiscal Responsibility and Budget Management (FRBM) panel to narrow the fiscal deficit to 2.5% of GDP by March 2023 for both Centre and states each, it can be an important starting point. The existing FRBM aims at reducing combined fiscal deficit to 6% of GDP vs the proposed 5%.

The writer is head, South Asia Economic Research (India), Standard Chartered Bank, India